Laddering with Individual Bonds

Duration matching is not straightforward for bond funds when
shares of the bond fund must be sold to meet ongoing retirement expenses. If
rates have risen, shares of the bond fund may need to be sold at a loss, with more
shares sold to meet a given spending objective. This triggers sequence risk and
locks in losses. Immunization only works if interest payments can be reinvested
at a new higher interest rate to compensate for capital losses. But not all the
funds are fully reinvested when a spending goal is met, so reinvestment risk
and interest rate risk do not get neutralized. The return on remaining assets
would need to be even higher to keep the retirement liability funded.
Immunization is harder when there is also a spending goal to support.

For additional information, click here to download our resource, 7 Risks of Retirement Planning.

A more practical approach is to use individual bonds in a
retirement income plan. A retirement income bond ladder can be structured so
the cash flows provided through coupons and maturing face values will provide a
steady and known stream of contractually protected cash flows for the ongoing
expenditure needs in retirement. Cash flows from the bonds are matched to fund
desired expenses at desired dates. Interest rate risk can be ignored for the
retirement expenses that have been matched with these dedicated assets.
Sequence risk is reduced because there is less risk of assets being sold at a
loss. Rebalancing may be required in terms of extending the length of the bond
ladder as time passes to cover future expenses, but the complexities involved
in an ongoing effort to match durations can be better avoided.

Retirement income bond ladders generally take the form of
Treasury bonds to minimize the possibility of default risk. For a household
retiree, maximizing investment returns is not the goal; the goal is to meet
expenses. Paper losses on individual bonds do not have to be realized if the
bond is held to maturity. While the retiree misses out on the opportunity to
buy the bond at a lower price later, this cannot be known in advance. It is
always unfortunate to buy bonds and then see the price drop due to rising
rates. But if the initial purchase allows the retiree to meet his or her
retirement objective, then it is a successful purchase, no matter what interest
rates subsequently do.

Retirees who realize that it is nearly impossible to predict
interest rate fluctuations can take comfort in knowing that individual bonds
allow them to enjoy retirement and ignore subsequent interest rate
fluctuations. Ignoring interest rate fluctuations is not possible with a bond
fund strategy that has to make frequent adjustments to the portfolio’s duration
in order to immunize against interest rate risk.

The difference between a traditional bond ladder as an
accumulation tool and a retirement income bond ladder is that with a
traditional ladder, the cash flows received as coupons and face value are
reinvested to purchase new replacement bonds at prevailing prices that extend
the ladder and keep its length relatively constant over time. With a retirement
income bond ladder, the cash flows received are spent on planned retirement
expenses. A retirement income ladder will naturally wind down if other assets
from outside the ladder are not used to extend it further as time passes.

As we have discussed, changing interest rates lead, in turn,
to capital gains or losses for investors. For professional bond traders, rising
interest rates would be a serious problem for someone who had just purchased a
long-term bond. Most traders have no intention of holding bonds to maturity and
will realize capital losses on the subsequent sale. Interest rate increases might
also force retirees owning bond funds into a position of selling shares at a
loss in order to meet retirement expenses. For a bond portfolio that is not
fully immunized, this triggering of sequence-of-returns risk can create
irreparable harm for retirees.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

 


Originally posted at https://retirementresearcher.com/laddering-with-individual-bonds/

→ Save time. Save paperwork. Save dollars. Esurance ←